Aligning Fund Manager Incentives with Shareholder Interests

How new standards are helping to create appropriate manager incentives

Jan 09, 2018

Don Phillips

The mantra of management is that you get what you measure. If you
want more employee face time in the office, measure their entrances
and exits. If you want greater safety in the workplace, measure the
number and severity of accidents. It stands to reason; people respond
to the pressures and incentives placed upon them.

Mutual fund managers, of course, are no different. If you incent
them to generate high yields, they will stretch for added income. If
you reward short-term performance, but ignore risk, they will shoot
for the moon.

Shareholder interests typically have taken a back seat

The problem in the mutual fund world is that for years these
incentives were applied for the apparent benefit of the asset manager
and not necessarily to favor shareholder interests. It was commonplace
to base portfolio manager compensation on the size, rather than the
performance, of the fund they were managing.

Bigger rewards for those shouldering a bigger load make sense
within the halls of the management firm: A bigger fund is a bigger
profit source and all of the firm’s employees know that. But fund
shareholders don’t care about fund company profits, they care about
their own experience. They want their portfolio manager researching
securities, not schmoozing with brokers, but the manager was often
incentivized to do just the opposite.

While better performance should in time bring more assets, that’s a
tenuous link that may take years to realize. Getting a broker to sell
more shares today has an immediate impact.

Manager incentives lead to predictable results

When fund companies did include performance in managers’
evaluations, it was too often focused on the short term and downplayed
or ignored the risks taken to achieve that performance. Fund companies
knew that hot performance generated news coverage through quarterly
leaders’ rankings and profiles. To be a top fund in a calendar year
was certain to generate lots of press coverage. As the head of one
major fund company once told me: “A management consultant told us that
the way to move the needle in the no-load world was to have a fund
rank in the top decile of its category for the year, so we aligned all
our manager incentives to generate top-decile annual returns.” In the
process, risk was discounted, costs downplayed, and any performance
outside the calendar year ignored.

The results were entirely predictable: The firm got more top-decile
results, but it also got more bottom-decile results. Their managers
who were in the middle of the pack in November would take crazy risks
to try to jump up the performance rankings before year-end, knowing
that if they won, they’d get big bonuses—and if they lost, they’d get
a clean scorecard on Jan. 1.

In pursuit of new shareholders, the firm incentivized managers to
regularly blow up their funds and damage their long-term risk-adjusted
performance—just what existing shareholders would not want. And the
ultimate irony was that the new shareholders they did attract when
successful were among the most fickle imaginable. They loved the fund
when it was hot and abandoned it as soon as performance cooled.

New standards better support shareholder interests

Fortunately, the incentive situation has improved considerably in
recent years. The Securities and Exchange Commission now requires fund
companies in the United States to disclose the incentives embedded in
their managers’ compensation. While these disclosures may not be
widely read by shareholders, the fact that Morningstar, advisors, and
consultants can access them as part of their stewardship assessment of
a firm makes a huge difference.

Fund companies now are far more likely to link manager compensation
to longer-term performance that often includes some sort of risk
assessment. Moreover, it is now required that fund companies disclose
in broad buckets the level of a manager’s own investment in the funds
that they manage. While the industry fought this disclosure tooth and
nail, there’s no better way to align manager and shareholder interests
than to make sure the manager is also a shareholder.

How Morningstar ratings have impacted manager incentives

Finally, it’s worth considering the role that Morningstar’s ratings have played in manager
incentives. The Morningstar Rating for funds, or star rating, has
limitations. The stars are a grade on past performance—and past
performance may not always be prelude to future returns, as many
variables can change in a fund or in the investment environment in
which the fund operates.

But as grades, the stars create incentives that are much better
than the short-term leaders and laggards lists that they have
displaced as evaluation tools. The stars are long-term-oriented,
include a risk measurement, and are highly correlated with expenses.
They thus encourage fund managers to keep costs down, to avoid wild
risks, and to think long term. In short, they create precisely the
incentives rational shareholders would want their fund managers to
operate under.

Morningstar Analyst Ratings go even further in their attempt to
create appropriate manager incentives. They are even more highly
correlated with costs, putting more pressure on managers to lower
fees. They also embed much of Morningstar’s stewardship work,
rewarding management’s alignment with shareholder interests through
investment in their own funds and favoring fund shops that have
created better investor experiences by shunning faddish concepts that
are easy to sell, but often blow up on shareholders.

Simply put, rational shareholders would far prefer their fund
managers to aspire to be a Morningstar Medalist than to top the
short-term performance derby.

Morningstar’s contribution to shareholder interests

At Morningstar, we’ve tried to make a positive contribution to
shareholder interests by pointing the industry toward better behavior,
lower fees, and more disclosure. In my opinion, we’ve had much success
over the past 30 years in doing so. There’s still work to do, but we
won’t stop trying to measure and reward those fund company behaviors
that most benefit investors.

This blog post is adapted from an article that originally appeared
in the December/January 2018 issue of Morningstar
magazine.Read the full article.

Read Morningstar magazine for more
credible, in-depth, and relevant analysis on the latest investing
trends.

Follow Morningstar

The Morningstar name and logo are registered marks of Morningstar, Inc. Opinions expressed are subject to change without notice. This commentary is for informational purposes only. Advisory and discretionary management services are provided by one or more Morningstar, Inc. subsidiaries, which are authorized in the appropriate jurisdiction to provide such services. For more details, click here. The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Morningstar has not considered any individual’s circumstances in preparing this information. Before making any investment decision, please consider consulting a financial or tax professional regarding your unique situation and consider the relevant disclosure document.